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Deconstructing Tyco

So why did Tyco management suddenly decide to break up the conglomerate? Some say it's the accounting, stupid.
Jennifer Caplan, CFO.com | US
April 1, 2002

Prologue:

On Jan. 22, senior management at Tyco International made a startling announcement. In a corporate press release, Tyco executives let it be known that they intend to dramatically alter the structure of the corporation. At the heart of that restructuring: breaking up the company's four operating units into separate businesses, then spinning those businesses off as standalone, publicly traded companies.

In explaining the plan, Tyco CEO L. Dennis Kozlowski seemed to trumpet the virtues of pure-play companies over conglomerates. "Over the past decade, Tyco's share price has increased ten-fold as we have used Tyco's size, access to capital and operating philosophy to build world-class businesses," he noted. "These businesses have now developed to a size and stage where they can thrive on their own and perhaps be even more agile than Tyco."

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Kozlowski's explanation would have made sense, too, if Tyco hadn't spent the better part of the Nineties eagerly cobbling together an empire. In fact, it wasn't all that long ago that the Bermuda-based Tyco was being billed as the next General Electric. From 1993 to 2001, the company shelled out a jaw-dropping $64 billion on 200 acquisitions -- a buying spree not seen since the days of John D. Rockefeller, Commodore Vanderbilt, and other men with tall hats. Tyco's long string of purchases covered a wide spectrum of businesses -- from syringe makers to security systems specialists.

Not surprisingly, Tyco management's plan to dismantle the $36-billion-in-revenues conglomerate left many investors and analysts flummoxed. "This drastic change from Tyco is very strange," says Tom Burnett, president of Merger Insight, an affiliate of Wall Street Access. "Tyco management held an analyst meeting only a few months ago when it was extolling the virtues of the combined, diversified enterprise. Now it is completely trashing that concept."

In turn, some Tyco watchers are now trashing the company's explanation as to why it's breaking up its empire. These observers claim Tyco's seismic shift in strategy is more about bookkeeping than agility. They assert that rising investor concerns over financial reporting has made it tough for any acquisitive corporation to wring double-digit earnings growth from aggressive purchase accounting. Says Albert Meyer, a short seller at investment research firm Tice Associates: "Tyco management ran out of help from their accountants."

Swell Cookie Jars
They ran into some bad luck, that's for sure. The downturn in the U.S. economy -- and the cash crunch it triggered -- put a spanner into the works of many deal-making companies. The tightening of the commercial paper marker, for instance, has made it difficult for many corporations to raise short-term capital.

What's more, the unexpected demise of Enron Corp. late last year triggered a national outcry over corporate accounting practices. Many observers insist that aggressive corporate bookkeeping -- often rewarded by investors in the go-go days of the late Nineties -- no longer plays in the post-Enron era. "The days of pushing the envelope are over," says Meyer. "Tyco realized that it just wasn't going to be able to make its numbers without some massaging."

One Tyco watcher goes as far as to say that the company's auditor, PricewaterhouseCoopers, may have suggested the spin-off strategy to Tyco management. A Tyco spokesman denies the assertion. "That is 100 percent false," says Brian McGee, executive vice president at the company. "There was absolutely no pressure or even a suggestion of the sort from our auditors." CEO Kozlowski insists that the company's restructuring plan had been in the works six months before the Jan. 22 announcement. He says the break-up is necessary to unlock shareholder value by as much as 50 percent, help the company pay down more than $11 billion in debt, and allow for more transparent financial reporting.

But given heightened investor sensitivity to earnings guidance -- and revenue restatements, it's not inconceivable that an auditor would advise a client to take a more conservative tack in its bookkeeping (a spokesman at PricewaterhouseCoopers declined to comment for this article, citing client confidentiality). If Tyco senior executives have decided to take a less aggressive approach in their accounting, the move could make it harder for them to meet the company's ambitious revenue targets. Such a likelihood might explain the company's Jan. 22 announcement.

Indeed, Many Tyco critics have long argued that the company manages its earnings by stretching the limits of generally accepted principles of accounting (GAAP). For one thing, these critics maintain that Tyco's finance department uses so-called "purchase accounting liabilities" to keep acquisition-related expenses (severance payments, facility closures, administrative costs, and the like) off the company's income statement.

In accordance with FASB's Emerging Issues Task Force directives, Tyco accrues for purchase accounting liabilities at the time of acquisition, effectively increasing the purchase price and adding the same amount to goodwill. When it incurs these expenses, Tyco credits cash and debits the purchase accounting liabilities, thus keeping expenses off the company's income statement.


Short-seller Meyer argues these purchase accounting liabilities become cookie jar accounts -- accounts which Tyco management can use at its discretion to absorb a variety of operating costs. "GAAP rules allow mainly for the capitalization of professional fees," Meyers argues. "But Tyco management lumps in a host of other expenses that don't make it into the income statement or cash flow numbers."

Of course, Tyco is not alone in its handling of these types of expenses. Edward Ketz, an associate professor of accounting at Penn State's Smeal School of Business, notes that many companies use purchase accounting liabilities to camouflage costs. When a company's operating expenses are hidden in liability accounts, Ketz says it becomes easier for that company to grow earnings consistently. Currently, Tyco is carrying more than $600 million worth of expenses in purchase accounting liabilities on its balance sheet.

But Bob Willens, a tax and accounting specialist at Lehman Brothers, insists that Tyco is playing by the rules. "The accounting they employ is of very longstanding validity," he says. "The EITF [Emerging Issues Task Force] directs that where in connection with an acquisition a restructuring charge is taken, that charge is part of the purchase price for the target company and is therefore part of the goodwill that arose from the acquisition."

Dressing Down the Tarting Up
Even Tyco critic Meyer concedes that Tyco's practices are consistent with GAAP. Nevertheless, he argues that Tyco management often resorts to financial machinations to suit its interests. One example: Meyer claims the company repeatedly lumps operating expenses in with acquisition-related charges, thus hiding costs.

The company also tends to include a lot of one-time or non-recurring charges on financial statements. Disclosures for these special charges in 10-K filings tend to be voluminous and complex. During the 12 quarters ended September 31, Meyer claims Tyco took $2.4 billion in special charges, at an average of $200 million per quarter. Critics say it's much easier for Tyco management to show expanding operating margins by reporting a raft of non-recurring charges. Moreover, a number of Tyco critics claim the company's management makes its deals look better than they actually are. How? By artificially deflating the operating results of an acquisition target in the final weeks before a deal is closed, they charge.

Take the case of Raychem Corp, a maker of power arresters, leak detectors and other electronic devices. Tyco bought the manufacturer for about $3 billion in cash and stock in 1999. In a recent article in the Wall Street Journal, the treasurer at Raychem claimed Tyco executives urged him to speed up bill payments in the months before Raychem was bought.

According to the story, Lars Larsen, then Raychem's treasurer, sent an E-mail to finance department employees at the time of the acquisition. In that message, Larsen reportedly said, "Tyco would like to maximize cash outflow from Raychem before the acquisition closes." Larsem added that Raychem "agreed to do this, even though we will be spending money for no tangible benefit either to Raychem or Tyco."

Tyco's McGee denied Larsen's claims, telling the Journal that the payments discussed in the E-mails were investigated by the SEC in 1999 and 2000 as part of a more comprehensive examination of Tyco's accounting. The commission ended its investigation in mid-2000, however, taking no action against Tyco.

Nevertheless, the Raychem incident is not the first time Tyco has been accused of tarting up deals by speeding up payables and slowing down receivables, "This becomes even easier to do," notes Penn State's Ketz, "when (a company's) acquisitions are not disclosed publicly."

700 Deals Tend to Add Up
Apparently, Tyco does a lot of that. In February, Tyco management acknowledged that it spent about $8 billion over the past three fiscal years on 700 acquisitions -- acquisitions that were never made public. In fiscal 2001, Tyco paid $4.19 billion in cash for unannounced deals, which works out to about 37 percent of the $11.3 billion in cash the company spent on all deals that year.

Tyco does state in its financial filings the "net" amount of cash it pays for acquisitions. Mark Swartz, Tyco's CFO, reportedly said the company doesn't disclose details on its numerous smaller deals because they aren't "material" to a company as big as Tyco. But Swartz has reportedly said that Tyco may include more details about smaller acquisitions in future financial filings.

Others maintain that Tyco management takes advantage of accounting rules by writing down to zero the net asset value of the companies it acquires, thus allowing Tyco to capitalize most of the price it paid as goodwill on the balance sheet. And since the earnings hit from goodwill amortization has now disappeared courtesy of FAS 142, this strategy would seem to be all the more appealing. "The key question here isn't: 'Is the company's accounting practices illegal,'" notes Whall, "but rather 'Do they mislead investors,'" The answer in Tyco's case is that they do."

Some of Tyco's owners seem to agree. On February 8, a group of shareholders slapped Tyco with a suit claiming that company management routinely obscures company finances to artificially inflate its stock share price. The suit also alleges that Tyco uses accounting tricks to hide its true financial condition.


But McGee of Tyco dismisses the charges. "If we do everything according to the rules and we disclose everything in a 10-K, then how does that mislead investors?" he asks. "We are a company that is second to none in the level of disclosure we give."

Do Adjust Your Sets
In fact, some critics charge that Tyco presents too much information in its financial statements, making it difficult for investors to get a true sense of the company's financial well-being. Then again, the 10-ks and annual reports of many large conglomerates tend to be filled with pages and pages of financial footnotes and esoteric explanations.

So how can investors accurately assess Tyco's performance? In an interview with CFO in the fall of 2000, CFO Swartz said internal growth rates and swelling free cash flow were signs that the company's acquisition strategy was paying off. "It's the organic growth that is the report card on the health of the business," he said.

Using that gauge, Tyco may not be all that well. To be sure, the company's per-share earnings (EPS) have increased substantially -- and consistently -- over the last thirteen quarters. During the fourth quarter of 1999, Tyco generated a trailing twelve month EPS of 64 cents. A year later, that number jumped to $2.05. In Q4 of fiscal 2001, the company generated an EPS of $2.60. (Meyer uses trailing twelve-month numbers to even out seasonal factors that might affect financial performance.)

The jump in EPS is good news for shareholders. But Meyer insists that the company's solid growth in income has not been supported by an equally strong bump up in free cash flow. In fact, he asserts that Tyco's free cash flow per share has started to decline.

By his reckoning, Tyco generated 82 cents of free cash flow per share in the fourth quarter of 1999. But he estimates that the company's free cash flow per share in the first quarter of 2002 fell to 69 cents -- well below the company's 1999 levels. "If you do a true free cash flow analysis," asserts Meyer, "it becomes quite apparent that they are running out of cash."

At the very least, Tyco appears to cleave to an unusually loose definition of free cash flow. In fiscal 2001, for example, Tyco management reported the company generated $4.75 billion in free cash. But that figure excluded more than $2 billion in costs incurred by Tycom, the company's telecom business, to build an extensive underwater global communications network.

Meyer doesn't buy the bookkeeping. "Excluding Tycom expenses from the capital expenditures line in the cash flow statement is unheard of," he insists. "Tycom is a subsidiary like any other that spends money on capital items." When those costs are included as capital expenditures, Meyer claims, Tyco's free cash flow drops to $2.5 billion. Throw in acquisition-related expenditures, and, Meyer says, Tyco really only produced $1.6 billion in free cash flow last year -- a far cry from the company's $4.7 billion figure.

Of course, as a short-seller, Meyer might have an agenda in bashing Tyco. But Meyer is not the only Tyco watcher who questions the company's free cash flow numbers. "You definitely have to look at those acquisition-related costs," concedes Cindy Werneth, who covers Tyco for Standard & Poor's. Notes Werneth: "Since those costs are not included in Tyco's free cash flow number, you just have to understand what you are looking at, and make your own adjustments."

Tapping, Not Basking
If Tyco is suffering a cash crunch, you'd never know it from listening to company management. During a recent conference all, CEO Dennis Kozlowski told analysts that Tyco has "no liquidity problems." In the same meeting, CFO Swartz added that the company is sitting on a cash cushion of about $1.5 billion.

Nevertheless, earlier this month, Tyco and its finance unit, CIT, borrowed $14.4 billion through backup bank credit lines. The reason: Company management reportedly worried it would not be able to raise funds in the commercial paper market. The $14.4 billion came on top of $1.5 billion Tyco borrowed earlier to help the company execute its breakup plan. "When you have to tap your backup bank lines," comments Whall, "that's not exactly a sign of a company that's basking in excess cash."

Tyco's cash position probably won't get better any time soon, either. Debt at the company's industrial businesses nearly doubled to $21.6 billion during fiscal 2001. What's more, the soon-to-be dismantled conglomerate has some $12 billion in debt instruments coming due in 2003. Some analysts say management at the company may have a hard time paying down the debt. "The company's immediate cash needs have been taken care of, but next year it faces some substantial maturities," says Carol Levenson, director of research at Gimme Credit, a publisher of independent corporate bond research.

To raise cash, Levenson thinks, Tyco will have to sell some assets and push through the proposed spin-offs. Just how much capital Tyco can raise from deconstructing itself remains to be seen. Management recently acknowledged that it may have to pare down its spin-off plans due to unfavorable market conditions. And another worry: in February, Standard & Poor's dropped the company's senior unsecured debt rating three notches, to BBB from A. "We got concerned that they were not able to renew their bank lines and had to draw them down," explains S&Ps Werneth. "But that could just be a short-term phenomenon, given what's happening in the markets with Enron, etc. The company has some time to sort this all out."


Probably. Spokesman McGee definitely believes time is on Tyco's side. "By 2003 we will have completed the separation plan and restructured our debt," he insists. "We don't see liquidity as a problem going forward." And Tyco managers continue to insist that the company isn't under any real financial distress. Instead, they claim, the conglomerate is simply suffering from a general erosion of investor confidence.

Such a distinction may be lost on shareholders, however. Since the announcement of the break-up plan, the share price of Tyco common has plummeted almost 38 percent. The wicked free-fall has cost shareholders some $70 billion. That's a harsh accounting, by any standard.

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Epilogue:

On June 1, Dennis Kozlowski resigned as chairman and CEO of Tyco International. Reportedly, Kozlowski is under criminal investigation by Manhattan District Attorney's office. The reason for the inquiry? Allegedly, Kozlowski moved hundreds of million of dollars into family trusts and then used those trusts to buy goods and services -- without paying New York state sales tax.




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